This contains a 12 point plan to reform the entire US Internal Revenue Code. It addresses individual and corporate income taxes as well as the estate tax, sales tax and the taxation of foreign source income.
TUESDAY, MARCH 1, 2011
The Nickel, Dime, Quarter Tax
The present tax system of the United States is a disgrace. Exceptions in the form of deductions, credits, deferrals, exclusions and limitations have subsumed the general rules creating a code that is a bloated hodgepodge of more than 22,000 pages. For a whole host of reasons, US tax law badly needs reforming. Whether the political will exists to do so remains to be seen. The author’s purpose in establishing this website is to draw upon his 35 years of practicing tax law to set forth a 12 point plan to revise the Internal Revenue Code. This plan is referred to as the Nickel, Dime Quarter Tax.
The objective of the Nickel, Dime, Quarter Tax is to simplify existing law, lower individual, corporate and estate tax rates, remove economic distortions, return revenue streams to taxation, eliminate regressive payroll taxes, require all Americans whether receiving welfare, wages or investment earnings to file income tax returns, retain measurable progressivity and, finally, simplify the collection and administration of taxes. It is neither a Democrat nor Republican leaning proposal.
The underlying philosophy of the proposal is “shared sacrifice”, which, asks all Americans to pull together and do their part in these difficult times. Respectfully, President Obama’s approach creates so much divisiveness by drawing a line in the sand and saying all those who are on one side of the line will pay more and all those on the other won’t. This is no way to govern in hard times. Only through shared sacrifice will the country muster adequate resources solve its problems.
The Nickel, Dime, Quarter Tax Plan
Some features of this proposal are similar in spirit to the tax proposals found in the report issued in December 2010 by the President’s Deficit Commission. However, the breadth and scope of the Nickel, Dime, Quarter Tax is broader. The basic essentials of the Nickel, Dime, Quarter Tax are set forth below.
I. All income would be taxed at 5%, 10% or 25% (hence, Nickel, Dime, Quarter!)
Comment: The Nickel, Dime, Quarter Tax was conceived by your author. He believes his proposal will receive more attention if it has a catchy name. Other tax proposals have catchy names like the Flat Tax, the VAT tax, The Consumption Tax etc., so your author looked at his proposed rates of 5,10 and 25% and coined the phrase: The Nickel, Dime, Quarter Tax.
Under the proposal, the rich will pay exactly five times more than the poor. Under our current tax law, it is nearly impossible to determine how much more the rich pay than the poor, except in total. This is caused by deductions, credits, phase-outs, limitations based upon income, itemized deduction limitations, and the alternative minimum tax, to name a few. The Nickel, Dime, Quarter Tax takes all the guess work out of determining how much more the rich pay than the poor, eliminating the feeling just about all taxpayers have, whether rich or poor, that the system is not fair to them.
The poor would pay tax at a rate of 5% and the rich would pay five times more or 25%, with those in the middle paying 10%. This retains progressively. Compressing the rates at lower levels makes it easier to tax labor and capital at the same rate (see discussion below) which is key to achieving simplification.
II. All deductions and credits would be eliminated. Yes, ALL!
Comment: Eliminating all deductions and credits removes distortive economic incentives from the tax code. It allows free markets to allocate capital based upon market forces rather than upon the tax code. It gets Congress out of picking winners and losers. Deductions and credits are the source of much complexity in the tax code. Charities will be just fine as the much lower tax rates will leave taxpayers with more after-tax income.
Abuse of deductions and credits led to the enactment of the alternative minimum tax. It is perceived that the wealthy take advantage of deductions (loopholes) creating a fairness issue under the current code. The elimination of deductions and credits removes the need for an AMT. Dropping the AMT will eliminate much litigation between taxpayers and the government, kill loopholes and cease all tax shelter activity.
Finally, deductions, and credits make it difficult to calculate the effective tax rate between rich and poor taxpayers. If you asked the average man how much more tax a rich person pays than them, the answer would be elusive. Under the Nickel, Dime, Quarter Tax the answer will be clear. A rich person will pay five times more than a poor person. Deductions, credits, limitations, and cutbacks will not distort the effective tax rate between differently situated taxpayers.
III. All payroll taxes, i.e. Social Security, Medicare, Medicaid would be eliminated.
Comment: Eliminating all forms of social taxes withheld at source will remove a very regressive feature of our existing tax system. It will spur job growth by lowering the cost of labor. The existing perception that amounts “withheld” will be set aside by the government and will be there when we retire, become disabled or sick is an illusion. The facts are that the government has set nothing aside: One side of the government has merely borrowed and spent the money from the other side and given the latter an IOU. All of these programs are broke and so Americans might as well recognize that we are in a hand-to-mouth system for the payment of entitlements. We must all accept that there are no savings backing up the government’s promise to pay benefits. No endowment exists.
Social Security, Medicare and Medicaid are now like all other government programs, none of which have separate withholding taxes supporting them. They are largely supported by income taxes collected by the government…and borrowing.
Eliminating payroll taxes will help the poor by eliminating a regressive tax and opening up job opportunities. Of course, this will result in a loss of tax revenues that will have to be made up in other ways as outlined below.
IV. Welfare payments, Medicare and Medicaid would constitute income and taxed at 5%
Comment: Under the Nickel, Dime , Quarter Tax, income would include all forms of welfare, and, with no deductions or credits, nearly all adults will return to the tax rolls and file an income tax return paying a tax of at least 5%. This will support the notion of shared sacrifice where we are all pitching in to improve current economic conditions, not just those who earn more than $250,000, as the President has proposed. The government can protect the poorest Americans by increasing the amount of welfare payments by 5% to make them whole for the tax they will pay. The key to this proposal is that nearly everyone will file a tax return and contribute to the cost of government. This will foster a sense that the tax system is fair.
V. All income earned by charitable organizations and deferred compensation arrangements would be subject to tax at the rate of 5% on their income.
Comment: Charities do wonderful things, but if they retain and invest assets that produce income, they should pay their fair share for the benefits government provides to them. Hence, the rate of tax on income earned by charities will increase to 5%. Charities will pay the same rate of tax as welfare recipients pay.
Harvard has amassed an endowment of over $25 billion dollars. The Gates/Buffett foundation has $50 billion of assets now and will have over $100 billion upon Warren Buffett’s death. The country cannot afford any longer to allow income earned on assets transferred to and invested by charities to escape income tax forever.
All income on deferred compensation arrangements will be subject to current tax at 5%. Thus, 401(k) accounts will file returns and pay tax of 5% on income earned. Pension plans will pay a tax of 5% on income earned. Deferred compensation is too large of a revenue stream to ignore and the individuals enjoying the benefit of deferral must be called upon to do their part to solve our country’s problems
VI. Business activities of individual taxpayers conducted through sole proprietorships, S Corporations, partnerships or LLC entities, would be reported on a separate, uniform business tax return (which will be the same as that used by C corporations).
Comment: Our present tax code contains many rules designed to prevent taxpayers from deducting real estate and business losses against wages and other forms of income. These rules are commonly known as the passive activity rules. These rules will be eliminated by requiring all business income to be reported on a separate business tax return. Not only will income earned by Sub S corporations, partnerships, and LLC’s be reported on the business tax return, C corporations will also report income on the same business tax return.
All businesses will report income using the same rules and pay the same rate of tax as individuals pay. This will eliminate gaming that occurs when business income can be reported by individuals at lower rates than C corporations pay and vice versa. Under the Nickel. Dime, Quarter Tax, all business income will be taxed the same. The business tax rate will be 5%, 10% or 25% depending on how much income is earned. This maintains progressivity and is consistent with the notion of shared sacrifice.
The business tax will be integrated with an individual’s tax liability. Business income will be taxed once and only once. Thus, no tax will be paid on dividend income. This will eliminate the bias of capitalizing business enterprises with debt rather than equity. This should result in more stable capital structures.
VII. The alternative minimum tax would be unnecessary under the Nickel, Dime, Quarter Tax and would be eliminated.
Comment: The alternative minimum tax will not be needed under the Nickel, Dime, Quarter Tax because deductions are eliminated and business losses cannot offset other forms of income, which the AMT is designed to prevent. This will eliminate the ritual of patching the AMT year after year.
VIII. The tax treatment of wages and capital would be equal. The separate capital gains tax rate under current law would be eliminated.
Comment: The present tax law taxes wages much more onerously than returns on capital. Those worried about capital formation argue vociferously that capital must be given a more favorable rate than wages as capital is mobile and will go elsewhere if our incidence of tax is too high. They have largely succeeded in their argument since most forms of capital gains are taxed at only 15%, whereas wages are taxed at income tax rates up to 35%. And don’t forget payroll taxes, which boost the rate of tax on certain bands of income to well over 50%.
The Nickel, Dime, Quarter Tax eliminates the distinction between wages and capital. Hence, the capital gains tax rate will be eliminated. The present tax law contains numerous provisions which attempt to foil taxpayer attempts to convert ordinary income into capital gains. These provisions would not be needed under the Nickel, Dime, Quarter Tax and would be eliminated. This brings about much simplification.
Lowering the top tax rate to 25% in conjunction with integrating business and individual taxes will provide an acceptable level of tax on capital through the lowering of rates and the elimination of double taxation that applies to much business income today. Keep in mind that the capital gains tax rate was 28% not that long ago.
IX. The top corporate tax rate would be reduce to 25%, ordinary and necessary expenses would be deductible from business gross income, but all “incentive” deductions and credits would be eliminated.
Comment: The corporate tax system is riddled with deductions and credits. All incentive deductions would be eliminated under the Nickel, Dime, Quarter Tax in exchange for lower tax rates. Thus, corporations would not be permitted to deduct health care expenses, charitable contributions, player contracts, R & D expenses, oil depletion allowances, etc. Truly “ordinary and necessary” business expenses would continue to be deductible.
Small businesses would pay tax at a rate of 5%, medium size businesses would pay tax at 10% and large businesses would pay the top rate of 25%. Businesses would no longer have to pay half of their employees’ payroll taxes as those taxes would be eliminated under the Nickel, Dime, Quarter Tax, thereby lowering the cost of labor and making the US more competitive.
X. The top estate, gift and generation skipping tax rates would be 25%.
Comment: As with the income tax system, deductions and credits that are designed to incentivize conduct will be eliminated. For example, estates may currently deduct, without limitation, charitable contributions. Warren Buffet and Bill Gates are driving a truck through this provision and neither will pay any estate tax, (NONE!!) by leaving their vast fortunes to family foundations. The marital deduction would also be eliminated.
A problem with our current transfer tax system is that so few people pay transfer taxes. It is estimated that only 25,000 people per year will have to file an estate tax return, now that the estate tax exemption is $5,000,000 per person or $10,000,000 per couple. Under the Nickel, Dime, Quarter Tax, the base will be broadened such that those whose gross estates exceed $1,000,000 will pay a 5% estate tax, those whose gross estates exceed $3,000,000 will pay 10% and those whose estates exceed $15,000,000 will pay estate tax at a rate of 25%.
Broadening the base like this is consistent with the notion of shared sacrifice, and graduating the rate sets the contribution according to ability to pay. Let’s also not forget that much of the net worth of those with more than a million dollars, accumulated their wealth through government subsidies related to ownership of their homes, including the deduction of interest, deduction of real estate taxes and the exclusion of up to $500,000 of gain realized on the sale of a home.
XI. The current US worldwide system of taxing foreign earnings would be retained under the Nickel, Dime, Quarter Tax. However, the deferral of foreign earnings permitted under current law would end.
Comment: The taxation of the foreign earnings of US corporations is very complex. Suffice it to say, our present system encourages the flight of capital from the US to foreign countries that have lower tax rates than the US’s. Our current system held up fairly well when most direct investment from the US was to European countries whose tax rates were generally equal or higher than US rates. As global competition has intensified, many countries have lowered their rates to attract foreign capital. This has been coupled with the evolving attractiveness of investing in emerging markets, where corporate tax rates traditionally have been meaningfully lower than the US corporate tax rate.
To complete the picture, GAAP accounting rules provide an incentive for US multinationals to invest in lower tax countries and keep their profits abroad. Under GAAP rules, US companies do not have to recognize currently as an expense, the US tax liability associated with bringing low taxed foreign earnings back to the US through dividends. Thus, the eventual US tax expense is deferred under GAAP until the parent decides to bring the money back to the US.
A short example may aid understanding. Assume a US parent company has $1,000 of capital to invest and that it can earn a 10% return ($100) before tax on such capital annually. If the investment is made in the US, the $100 of earnings will be taxed at 35%, leaving $65 of after tax earnings.
If the same $1,000 were instead invested through a subsidiary in Hong Kong and $100 earned, Hong Kong would impose a corporate tax of 17%, leaving $83 dollars of after tax earnings. If those $83 are repaid to the US, the US parent must pay an additional US tax of $18. The $18 dollars is equal to the difference between the tax paid to Hong Kong ($17) and the amount of US tax that would have been paid, had the parent earned the $100 in the US ($35) instead. Importantly, the payment of this $18 of US tax is deferred until it is brought back to the US (via a dividend) and the parent’s reported earnings are not docked under GAAP accounting until the $83 is returned to the US parent.
I ask: What CEO in her right mind would bring her $83 dollars of Hong Kong earnings back to the US, unless she was desperate? None. That is why it is estimated that $2 trillion of foreign earnings of US multinationals are sitting abroad, enjoying the deferral of US tax year after year. Your author is not sure if the aversion to pay a tax voluntarily or the desire to report higher earnings is stronger, but combining the two creates a huge incentive to keep low taxed, foreign earnings out of the US. Ironically, such capital remains perpetually outside of the US, turning it into “foreign capital” that competes against the US for jobs. Crazy!
Given this deferral advantage, the government and taxpayers have played a game of cat and mouse for decades. Multinationals attempt to achieve deferral through elaborate schemes. This has given rise to many complex tax provisions that end the deferral of US on low taxed foreign earnings in abusive situations, such as diverting profits to tax haven jurisdictions where limited operations exist. Such provisions include Subpart f, PFIC, and Foreign Personal Holding Companies. All such provisions will no longer be needed as deferral of US tax on foreign earnings will end under the Nickel, Dime, Quarter Tax.
Of course, many CEO’s will scream bloody murder over this proposal (including GE’s Jeffrey Immelt!), but they must keep in mind that their top tax rate will go down to 25% and their shareholders will pay no further tax upon receipt of corporate dividends.
XII. A 9% national sales tax will apply to sales of most property and services, with 6% rebated to the states. If states wish to impose a higher sales tax, they can do so at their peril.
Comment: Your author asks: Does it make sense to impose a sales tax on a TV if it is purchased locally at a Best Buy store, and not impose a similar tax if it is purchased over the internet? Your author further asks: If a US manufacturer produces a widget and sells it to Europe, it must tack on a VAT tax, thereby pushing up the cost of its product, whereas a foreign manufacturer can import its widget to the US, without the payment of a sales or VAT tax? How fair is this? The US exporter is at a competitive disadvantage.
Under the Nickel, Dime, Quarter Tax, a federal sales tax of 9% will apply to the sale of most goods and services. Six of the 9% will be rebated to the states and 3 of the 9% will go to the federal government. Certain essential items will be free of tax and certain essential goods (food and clothes) will be assessed tax on amounts that exceed thresholds.
The Nickel, Dime, Quarter Tax is simple, doable and beneficial.
Everyone will benefit from the simplicity of the proposal. A tax return will have a few lines on one page and when you are done, you will not have to recompute your income tax again using another set of AMT rules.
It is doable because everyone is treated the same, except for a progressive rate structure – 5%, 10% and 25%. This makes the difference between the tax burdens of the rich, the average and the poor measurable. This is a key to the perception of fairness and shared sacrifice.
It is beneficial because our tax system will no longer pick winners and losers . There will be no tax subsidies to distort economic behavior. The market alone will drive decisions. It is also beneficial as the cost of labor will lessen, thereby increasing employment here in the US. Capital will flow back to the US from tax havens and be used here to create jobs rather than remaining abroad perpetually.